401(k) Financial Planning Retirement Income Retirement Planning Tax Planning

Understanding the Two Roth IRA 5-year Rules

Many would agree that Roth IRAs are special retirement accounts. They are funded with after tax dollars, grow tax deferred, and all distributions including accumulated gains are tax free.

…Or are they?

There are two five-year rules that govern whether your Roth IRA distributions are both tax and penalty free. The rules can be quite complex, and confusing. They are often a mystery to many financial professionals, and those who are aware of them often have a hard time comprehending how they work.

In order unleash the power of Roth IRAs in your own financial plan, and to proceed with confidence, it is imperative that you understand how these two 5-year rules operate.

The First 5-Year Rule; The One to Rule Them All

This rule is a bit like Tolkien’s Ring of Power from the Hobbit and Lord of The Rings series. Like the one Ring of Power that rules all the other rings, there’s one 5-year rule that rules all of your Roth IRAs.

The first of the 5-year rules are probably the most important one and in my opinion the more favorable of the two. For Roth IRA accumulation to be received tax and penalty-free the law states that you must have had a Roth IRA open for a minimum of five years.

Understand this. Opening a single Roth IRA will do it.  There’s no minimum contribution requirement for it to count. If you have had a Roth IRA open for at least 5 years this rule is satisfied.

For example, you opened a Roth IRA with $500 in June of 2010. The 5-year rule is on a calendar basis, therefore for purposes of determining how long your Roth IRA has been open we go back to January 1 of 2010. That is your starting point. Obviously by now your Roth IRA has been open for more than five years old, and the first rule is satisfied.

Let’s pretend for a moment that you opened a 2nd Roth IRA 2 years ago, and you made a maximum contribution of $6,000. It has now grown to $6,600. How long do you have to wait before you can access your new Roth IRA account without taxes or penalty?

The answer, you don’t have to wait at all. The initial Roth IRA that you opened back in 2010 satisfied with the first of the 5-year rules.

You could have many different Roth IRA’s open at various times, but so long as you have one that has been in existence for over five years, all your other Roth IRAs regardless of when they were open have now satisfied with the first 5-year rule.

It’s the one Rule to rule them all (all your Roth IRAs that is).

For this one reason we encourage folks to open a Roth IRA immediately if they never have done so in the past. Just starting the clock on the 1st of the 5-year rules is a step in the right direction for most folks. Even if you start a Roth IRA with a small amount of money you can satisfy the five-year rule and open up your ability to use Roth IRAs in your future planning without the impediment of the 1st 5-year rule getting in your way.

Roth Conversions and the 2nd 5-year Rule

For decades workers have been encouraged to defer income inside of their 401(k)s, IRAs, and other IOUs to the IRS. CPAs, HR personnel, and many financial professionals have been preaching tax deferral as though it were a tax savings. But is it always a tax savings?

Whether deferring taxes today will become a tax savings or not depends on what tax rates look like in the future. What tax rate will be paid when you make distributions from these pretax accounts? If the tax rate is higher in the future, then deferring taxes today is not a tax savings at all.

Many folks are learning that tax rates are historically low today. They see mass government spending programs driving national debt higher as a catalyst for inevitable future tax rate increases. For these folks, what once was thought as a tax savings by deferring taxes into the future is beginning to look more like a future tax problem. They may want out while they can at historically low tax rates.

Roth conversions may be just the ticket for these folks. They allow you to control how and when you pay taxes on your IOUs to the IRS.

When you convert money from a forever-taxed account like an IRA, to a never-tax account like a Roth IRA, you are obligated to pay taxes on the conversion. The amount of the conversion is added to your taxable income for the year in which you do it. However, your Roth IRA now grows tax-deferred and distributions forever freed from the grips of the tax man.

The 2nd of the 5-year rules governs Roth IRA conversions. There’s a specific reason it exists, and we’ll address that first.

For most folks, a distribution from a pre-tax account like an IRA prior to reaching age 59 1/2 will result in 10% penalty for early withdrawal from a retirement account. After all, IRAs, 401(k)s, and other IOUs to the IRS are designated as retirement accounts. It was the intention of congress to extend tax-deferral privileges to these accounts to encourage folks to save for retirement.

Roth IRAs on the other hand can be accessed prior to 59 ½ so long as the first of the 5-year rules is met. Someone under the age of 59 1/2 for example could withdraw from her Roth IRA without incurring a 10% penalty if she opened the Roth IRA more than 5 years prior.

So, what is the stop this person who has had a Roth IRA open for more that 5 years (satisfying the One Rule that rules them all) from converting her pre-tax IRA which would incur a 10% penalty for early withdrawal to a Roth IRA, and then immediately distributing the after-tax balance without a 10% penalty for early withdrawal?

Imagine someone is under the normal retirement age of 59 ½. She desires to access her IRA without penalty. She opened a small Roth IRA 20 years ago, so the first five-year rule has been satisfied. She’d be penalized for pulling money out of her traditional IRA, but she’s smart and decides to convert her IRA to a Roth IRA. She still must pay taxes, no different than if she’d made a distribution from her traditional IRA. However, now she could pull that money out prior to 59 1/2 without a 10% penalty whereas in the traditional IRA should be penalized.

Lawmakers thought about this too. To prevent this type of behavior they wrote in the 2nd 5-year rule.

When a conversion is made a 2nd 5-year clock begins. To avoid any penalty for early withdrawal from a Roth IRA conversion you must hold it for a minimum of 5 years. Unlike the 1st 5-year rule, each conversion has its own 5-year period.

For example, if a person were to make a $20,000 Roth IRA conversion this year, and each subsequent year thereafter for 5 years straight that person would have five separate five-year rules to keep track of, one for each conversion.

It’s the second five-year rule that prevents folks under the age of 59 1/2 from bypassing the 10% penalty for early withdrawal from retirement account.

If an IRA owner decides that she would like to access $25,000 of her IRA prior to 59 ½, and she converts her IRA to a Roth IRA she would still incur a penalty for early withdrawal until the fifth year has passed.

When you make a conversion, the taxes are paid. So, it’s not as if you’re avoiding taxes of the traditional IRA, or and additional tax for making an early withdrawal. We’re talking specifically about the 10% penalty for early withdrawal from retirement account.

Therefore, if you were over 59 ½, and you convert an IRA to a Roth IRA that 10% penalty doesn’t apply to you anyway. Therefore, folks who are over 59 ½ who make Roth IRA conversions really don’t have to worry about keeping track of the 2nd 5-year rule because it won’t impact their ability to access their Roth IRA conversions.

In Conclusion

It is often advised that you open a Roth IRA if you haven’t done so. The best time to open a Roth IRA would’ve been years ago, but the second-best time would be right now. Get your five-year clock started even if it is with a small contribution or conversion. Unlock the financial planning power of this special section of IRS tax code so that you can use it within your own written retirement plan effectively. It is also wise to seek tax advice from your tax planning professional, and to work with a financial planning professional before making any decision about whether a Roth IRA or Roth IRA conversions are a fit for your long-term goals.